Adam Smith, The Wealth of Nations, 1776 The Flow of Money and Goods in a Market Economy

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1 Who Decides What? In the process of answering the three economic questions, every society develops an economic system. An economic system [economic system: a society s way of coordinating the production and consumption of goods and services] is the way a society coordinates the production and consumption of goods and services. Economic systems are as old as humankind, so you might expect there to be many different models. But if we strip away all the cultural differences that exist between all the societies that ever were, we find that history has produced only three basic types of economic systems. There are those built on tradition, those based on the command of rulers, and those organized by free markets. Each system answers the three economic questions differently. And each emphasizes different economic goals. Traditional Economies: Decision Making by Custom The first and oldest economic system is the traditional economy. Traditional economies have existed since the first clans of hunter-gatherers emerged in Africa. In a traditional economy [traditional economy: an economic system in which decisions about production and consumption are based on custom and tradition], custom and tradition dictate what to produce, how to produce it, and for whom. Most traditional economies that survive today belong to indigenous people who live much as their ancestors did hundreds or thousands of years ago. The Maasai of East Africa, for example, are a seminomadic herding people. Livestock, primarily cattle, is the mainstay of their economy. Maasai wealth is measured in cattle and children. The traditional Maasai diet consists primarily of meat, blood, and milk from cattle. The Maasai s answer to the question of what to produce is cattle, because it is their centuries-old tradition to raise cattle. As for the question of how to produce, people in traditional economies engage in farming, herding, fishing, hunting, and the gathering of wild plants. Exactly who does what is determined by social customs. Labor is often divided along gender lines. Among the Maasai, for example, men build enclosures to protect the cattle from lions. Boys graze the cattle. Women and girls milk the cattle. Among the Khoi-San people of the Kalahari Desert in Southern Africa, men hunt and women gather. For whom to produce is another question decided by tradition. Social hierarchies play an important role. A good illustration of this is the way meat is distributed among the Khoi-San people of the Kalahari. After a hunt, the kill is divided up, with a large share going to the hunter. He gives some to relatives, and they give part of theirs to other relatives, all according to the accepted social order. In the end, everyone gets enough to eat. The highest goals of people in a traditional economy are economic stability and security. Most want nothing more than to live as they always have, following traditional ways of life, in harmony with nature. For most traditional societies, though, this goal is increasingly difficult to attain. Traditional economies have become shrinking outposts of the past surrounded by the modern world. As modern economies exert an ever-growing influence, traditional societies are struggling to find a path to economic survival. Command Economies: Decision Making by Powerful Rulers

2 The next economic system to develop is what economists call a command economy. In a command economy [command economy: an economic system in which decisions about production and consumption are made by a powerful ruler or government], decisions about what, how, and for whom to produce are made by a powerful ruler or some other authority. The earliest command economies originated in Mesopotamia, Egypt, China, and India about 5,000 years ago. As these civilizations became highly advanced, centralized governments arose that were headed by powerful rulers. These rulers imposed their economic choices on society. This happened even as tradition still guided economic activity at the lower levels of society. Rulers at the top of these early civilizations kings, pharaohs, emperors commanded the populace to devote economic resources to building projects or military adventures. Many thousands of people might be conscripted to build a pyramid, defensive wall, irrigation canal, temple, or road. In a preindustrial age, such projects took vast quantities of human labor. Often, many people would be drafted into a ruler s army and sent into battle in distant lands. The primary goal of these ancient command economies was to accumulate wealth and goods for the ruling class while preserving economic stability. The many monuments these societies left behind are a testament to both the productive power of these economies and the excesses of their rulers. Market Economies: Decision Making by Individuals The newest economic system to emerge in human history is the market economy. A market economy [market economy: an economic system in which economic decisions are left up to individual producers and consumers] depends not on tradition or command to coordinate its activities but on the decisions of individual producers and consumers. Note that when economists speak of the market, they are referring to the economic system within which buyers and sellers exchange goods and services. This is distinct from an everyday market, which is a place where people buy and sell goods. In a free market economy [free market economy: an economic system in which the workings of the market are not planned or directed], the workings of the market are not planned or directed. No one no single person, business, or government agency tells producers or consumers what to do. Economic decisions are made voluntarily, one at a time, by millions of individuals guided by self-interest. The highest goals of a market economy are economic freedom and efficiency. Individuals and businesses are left at liberty to decide what, how, and for whom to produce. The producers of goods and services make these decisions based largely on consumers spending decisions. Because you are free to buy what you want, producers must compete for your dollars. This competition means that you, the consumer, have many choices. It also forces producers to use resources efficiently. If they do not, a competitor will find a way to offer the same good or service at a price that consumers will be more willing to pay. In a free market, individuals are encouraged to pursue the jobs that allow them to make the most of their human capital. If one employer fails to pay them what they think they are worth, they can quit and seek employment elsewhere. Or they can start their own businesses, perhaps even offering new products or services to consumers. You might expect that the result of all this individual decision making and competition would be chaos. But as the marketscoordinate-trade principle reminds us, just the opposite is true. Markets are highly efficient at producing a great variety of goods and services that people find attractive and at prices they are willing to pay. It was this coordinating power of markets that Adam Smith famously described as the invisible hand. He wrote, Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

3 Adam Smith, The Wealth of Nations, 1776 The Flow of Money and Goods in a Market Economy The reason markets work so well is that one person s output always becomes another person s input. Goods are produced and consumed. Money comes in and goes out. This flow keeps the economy running. Economists use the circular flow model [circular flow model: a diagram that shows the circular movement of money, resources, and goods and services among households and producers in an economy], like that in Figure 3.3, to illustrate these interactions. In the simplified market economy shown in the model, there are two kinds of participants: households and firms. A household [household: a person or a group of people living together] is made up of a person or of a group of people living together. The model assumes that households own the factors of production. A firm is an organization that uses these factors to make and sell goods or services. The model also shows two kinds of markets. One is the product market [product market: a market in which firms sell goods and services to households], in which goods and services are sold by firms and purchased by households. Your local mall or supermarket is part of the product market. The other is the factor market [factor market: a market in which households sell land, labor, and capital to firms], in which households sell their land, labor, and capital to firms. A household, for example, might rent land to a firm. Or members of a household might sell their labor to a firm for wages. They might loan money to a firm in exchange for interest payments. Or they might buy a firm s stock in the hopes of receiving dividend payments. The funds paid to households whether in the form of rent, wages, interest, or dividends are known as factor payments [factor payment: income earned when an individual sells or rents a factor of production that he or she owns; for example, wages are a factor payment made to workers in exchange for their labor]. Follow the arrows of the diagram to see the circularity. Households buy products from firms with money that they receive in the factor market. Firms acquire land, labor, and capital from households using money that they receive in the product market. For example, you (as part of a household) might buy a pair of jeans from a firm with money that you earned by working at a local ice cream parlor (another firm). The ice cream parlor, in turn, pays you for your labor with money that it receives from selling ice cream cones to other households. All these transactions are conducted by people and businesses who want something for themselves. People work so they can buy things. Firms employ people so they can make things to sell. In a market economy, everybody chooses what is best for him or herself. As Adam Smith wisely observed, It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.

4 Capitalism Gives Rise to Socialism and Communism Market economies emerged in Europe in the 1700s and began to grow rapidly in the 1800s. This economic growth was a direct result of the Industrial Revolution [Industrial Revolution: a period of rapid industrial growth and development during the 1700s and 1800s]. During the Industrial Revolution, new inventions and manufacturing processes spurred the growth of industry. Individual investors, called capitalists [capitalist: an individual investor who accumulates capital, such as machinery, factories, and railroads], grew wealthy by accumulating capital, including machinery, factories, railroads, and the like. The term capitalism [capitalism: the free market economic system] came to be synonymous with the free market economic system. The headlong growth of capitalism had profound effects on society. As more and better goods became widely available, people s standard of living improved. But capitalism did not improve the quality of life for everybody. The workers who filled the factories and mills labored under harsh conditions. Hours were long, and wages were low. Critics of capitalism blamed the capitalists for exploiting workers and keeping them in poverty. In 1848, economist Karl Marx and philosopher Friedrich Engels published The Communist Manifesto, in which they advocated the overthrow of capitalism. They proposed an alternative vision of society known as socialism. Socialism [socialism: a political and economic philosophy based on collective or government ownership of a society s resources and means of production, with the goal of achieving social and economic equality] is a political and economic philosophy that calls for property to be owned by society as a whole, rather than by individuals, for the equal benefit of all. To bring about this socialist vision of society, Marx and Engels called on workers everywhere to revolt against their governments. Once the workers had gained power, private property and the free market would be replaced with national ownership of industry and more equal distribution of income. The final phase of socialism, in the view of Marx and Engels, is communism [communism: a political and economic system in which all property and wealth is collectively owned by all members of society; the final stage of socialism in Marxist theory], a political and economic system in which all property and wealth are owned by all members of society. In a communist society, class differences and the conflicts they create disappear. Once that happens, government is no longer needed to keep order. Instead of self-interest, people in a communist society are guided by Marx s famous slogan: From each according to his ability, to each according to his needs. Modern Command Economies: Decision Making by the State The ideas of Marx and Engels spurred the development of political movements dedicated to the creation of a workers paradise. But when the first successful communist revolution took place in Russia in 1917, it did not lead to the utopian society Marx had envisioned. Instead, the revolutionaries formed an authoritarian government that pursued its socialist goals with brutal force. The renamed Union of Soviet Socialist Republics, or Soviet Union for short, became the first modern command economy. In the Soviet Union, private ownership of property was forbidden. The state owned the factors of production. Economic planning [economic planning: the process by which economic decisions are made or influenced by central governments rather than by private individuals] was done by government committees of economists, production experts, and political officials. These central planning committees attempted to perform the functions of a market. They decided what goods and services should be produced. They decided which farms and factories should get which resources to produce what was planned. Committees also controlled prices and wages and decided how goods and services should be distributed. In theory, this kind of planning was supposed to ensure economic equity and security two important goals of a modern command economy. But the reality was very different. The planning committees could not keep track of the millions of products and prices in the Soviet system. Two Soviet economists described what happened when Goskomsten, the committee in charge of prices, raised the price that the government would pay hunters for moleskins. State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has already requested Goskomsten twice to lower purchasing prices, but the question has not been decided yet. And this is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices. Nikolai Shmelev and Vladmir Popov, The Turning Point: Revitalizing the Soviet Economy, 1990 In this planned economy, shortages were common. Long lines would form to buy whatever goods suddenly became available. But once a customer got to the front of that line, choice was limited or nonexistent. Planners made matters worse by ignoring the incentives-matter principle. The wages paid to workers were determined by government committees, not by a worker s ability or output. A poor worker could not be fired for slacking off. Nor could a

5 good worker be rewarded for working hard. Under this system, workers had little or no incentive to produce high-quality goods. They also lacked any incentive to innovate in order to increase productivity. As a result, production was slow, and the goods produced were often shoddy, far inferior to those produced in a market economy. The Soviet Union and other command economies did succeed in increasing economic equity and economic security for their people. But what good is a guaranteed income if there is nothing to buy? What markets do effortlessly, command economies struggle to do, usually with dismal results. Central planning was so inefficient and wasteful that the Soviet Union economy eventually collapsed. Since then, virtually all modern command economies have either failed or struggled to introduce market-based reforms.